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Wednesday, 4 January 2012

It doesn't work like that - government finances edition

This is intended to be a short "idiot's guide" to how government finances REALLY work. I'm writing it partly as background for my posts on economic policy in the UK and Eurozone (and maybe the US), and partly to debunk various urban myths about government spending.

Firstly, let's define some terms.

"Deficit" is the excess of government spending over its income
"Surplus" is the excess of taxes over government spending.
Please note that for the purposes of this post, these terms relate only to government finances, not to trade finances. We also use the terms "deficit" and "surplus" to mean the excess of imports over exports and vice versa, but that is not how they will be used in this post.

"Taxes" are the contribution of the population to government spending - this is by far the largest part of government income, but there can be other components to government income such as asset sales. "Taxation" is the process of obtaining taxes from the population.

"Fiat currency" is currency whose value depends on the economic worth of the issuing country rather than an underlying asset such as gold. In practice the value of a fiat currency depends on the perceived trustworthiness of the issuing government.

Now to the urban myths that I mentioned in my introduction. This is how most people think government finances work:

1. Governments receive taxes from their population
2. Governments determine their spending plans on the basis of those taxes
3. Governments spend the taxes they have received
4. If governments spend more than the taxes they have received, they have to borrow the difference

These beliefs lead to the following value judgements:

- Governments should only spend what they receive in taxation. A government that runs a deficit to fund public spending is irresponsible.
- Government borrowing is a bad thing because it has to be paid off from future taxation, which means higher taxes in the future. We should get rid of government debt and "live within our means".
- Government surpluses are a good thing because it means we are being prudent and can pay off debt.

The problem is the beliefs are wrong, and therefore the value judgements are wrong as well. Government finances don't work like that.

The first thing to get your head around is that government spending PRECEDES taxation. Yes, that's right - governments spend first, tax later. This is roughly similar to the precedence of bank lending over saving that I explained in a previous post. Just as banks lend, then look for reserves to settle that lending, so governments spend, then extract taxes from their populations to extinguish the debt obligations created by that spending. It's always been like that throughout history: kings go to war, borrow to pay for their campaigns, then extract punitive taxes from their subjects to pay off their debts. The fact that present-day governments are spending money on many other things than war doesn't change the way it works. They spend, then extract the taxes.

The fact that spending precedes taxation means that government must establish its spending priorities on the basis of ANTICIPATED income, not actual income. And as anyone who has tried to forecast a business budget knows, what you anticipate you will get and what you actually get can be very different. So the idea that government should only spend what it receives in taxation is actually impossible. Tax forecasting is about as reliable as weather forecasting. Even spending plans are by no means certain.

Deficits and surpluses

There is a prevalent belief that deficit=bad, surplus=good. This belief is even being forced into law in the European Union. But value judgements such as "good" and "bad" have no place in finance and economics. Government spends according to the priorities agreed with its electorate, and it taxes that electorate to extinguish the debt obligations arising from that spending. In a perfect world the taxation would exactly balance the spending, so there would be neither a surplus nor a deficit. However, the world isn't perfect and taxation rarely if ever exactly balances spending. There will therefore in practice always be either a deficit or a surplus. And budget plans have nothing to do with this either. Government plans to run a surplus may be completely undermined by a sudden economic downturn that causes tax receipts to crash. A surplus can turn into a deficit in one budgetary cycle.

In fact, because there is a time delay between government spending and taxation, there must always be a gap - a temporary deficit - within a budgetary cycle. This has to be funded, either with surplus taxation from the previous cycle, or if there is no surplus, by borrowing or by creating new money. If the currency in which government spends and receives taxes is tied to an asset such as gold, government has to borrow against the value of its holding of that asset in order to finance its spending. Conversely, if the currency is not tied to any asset but exists simply because the government says it does - what we call "fiat" currency - the government can print unlimited amounts of that currency, or it can borrow against the security of the productive assets of the country. For various reasons that I won't go into here, most governments don't choose to print money even if they have fiat currencies - they opt for borrowing. Short-term funding is used to cover the spending-to-taxation delay. Longer-term borrowing is used to cover deficits that aren't paid off within one budgetary cycle. Governments that run persistent large deficits over several years can end up deeply in debt.

Keynsian economics argues that governments should run surpluses in boom times and deficits in recession. This looks like a good idea - saving up reserves in the good times to cover the shortfall in recession, when tax receipts fall and benefits payments increase. The problem of course is how do you know when you are in good times so should be running a surplus? There are always calls on public money, problems to be fixed, pockets of poverty to be alleviated. And of course, when times are good governments believe they will last for ever, so there will always be more money and there's no need to save. The Blair/Brown government famously said they had "fixed Tory boom and bust". They had to eat their words.

The reality is that governments DON'T generally run surpluses in good times - they increase spending. But boy do they run deficits in bad times. So generally, governments tend to get deeper and deeper into debt.

There are exceptions, of course - for example, Germany and the Netherlands both run large surpluses. If a government runs a surplus, it has the option of cutting taxes and/or reducing debt. Government debt does not automatically reduce when there is a surplus. The government decides whether to pay off debt, and on this they should be guided by the electorate: if the electorate wishes the government to return that surplus in the form of tax cuts instead of paying off debt, that is what the government should do.

The idea that a government persistently running a surplus is more "prudent" than one running a deficit is another value judgement, and fundamentally wrong. A government that persistently runs a surplus is every bit as irresponsible as one that persistently runs a deficit, because it is overcharging its population for public services and reducing their capacity to provide for themselves.

Automatic stabilisers and other uncertainties

Automatic stabilisers are changes in government spending and income that help to smooth out economic highs and lows - rather as the stabilisers on a ship help to stop it rolling excessively in a storm. They are set up to happen automatically as a consequence of economic performance, and once established the government has little or no control over them. In general, in an economic downturn tax receipts fall and benefits bills rise, while in an economic boom tax receipts rise and benefits bills fall.

Examples of automatic stabilisers are as follows.

- When unemployment rises, tax receipts fall because fewer people are paying taxes. At the same time, the government's benefits bill rises because it is paying more in unemployment benefits.

- If there is a system of top-up benefits for low wages (as there is in the UK), wage cuts and short-time working when the economy is performing poorly also increases the government's benefits bill and reduces its tax take.

- If corporate profits decline due to poor aggregate demand, collapse of exports or other such economic problems, tax receipts also decline. Companies that make losses can carry those forward and offset them against future profits, too, so corporation tax receipts may take some time to recover.

- If corporate profits rise due to high demand in a booming economy, tax receipts rise

None of this is under government control. But these changes can be sufficiently large within one budgetary cycle to move the public finances from surplus to deficit, or vice versa.

There may be other areas of spending that occur as a consequence of things beyond the government's control, such as hardship payments to elderly people in cold weather and compensation payments to farmers for crop failure in drought. These are spending commitments which are not known in advance and the amount of which cannot be realistically estimated.

Automatic stabilisers and other uncertain spending commitments make it difficult if not impossible to maintain a balanced budget over the business cycle - as our European friends would like.

Government debt

People who have grown up with the Anglo-Saxon virtuous model "savings good, debt bad" tend to feel very uncomfortable if their country has much in the way of debt. It offends their values. But as I said above, value judgements have no place in economics and finance.

Government debt can be regarded in a number of ways.

1) It is deferred taxation. Debt obligations created by government spending are extinguished through taxation, so if the taxes aren't raised from current taxpayers, they fall upon future ones. Additionally, there is an interest cost to debt which has to be paid from future taxation even if the debt itself is not paid off. When people talk about government debt being a burden on their children and grandchildren, this is what they mean.

2) It is spending brought forward. Government debt is a way of enabling present citizens to share in a country's future wealth. If a country is growing fast and living standards are rising - as is the case in emerging markets, for example - future generations will have a better standard of living than their parents and grandparents who have worked hard to create that economic growth. Bringing forward some of that wealth from the future enables the older generations to experience some of the material benefits from their hard work. Note that this only applies in a young, growing economy. It should be obvious that in an older, richer economy that is stagnating, bringing forward spending from the future in this way benefits no-one and could leave future generations with a debt burden that they cannot service.

3) It is a savings scheme. In most countries, government debt is generally bought by their own citizens as an investment for their future, often - though not always - as part of pension schemes. In countries that have developed capital markets, the debt may additionally be bought directly or indirectly by the citizens of OTHER countries. Government debt is regarded as the safest form of investment, because it is guaranteed by a sovereign government and is backed by the worth of the entire country. Owning, directly or indirectly, the debt of the country in which they live makes people stakeholders in their country's future.

4) It is another form of money. Yes, I mean that. Or, if you prefer, it is a liquid asset which is backed by the productive assets of the issuing country - which is the same thing as money (see my definition of "fiat currency" above). The debt of rich fiat-currency-issuing nations such as the USA and UK is essential to the functioning of the capital markets - so much so that when that debt is in short supply, market representatives have been known to lobby for more to be issued.

Now, you ask - if government debt is simply another form of money, why not just issue currency? Provided that a fiat currency is allowed to float freely against other fiat currencies, there is in my view no reason to prefer debt issuance over currency issuance, or vice versa. I have heard it argued that fiat-currency-issuing governments should prefer to issue currency rather than debt, because currency would be interest free. Yes, there would be no interest to pay. But the interest cost on government debt issues is directly related to the value of the currency through its exchange rate. Issuing more currency reduces the value of each currency unit, which causes the exchange rate to fall, raising the cost of imports and creating inflationary pressures in the economy. Correcting those pressures involves increasing interest rates to private sector borrowers. The overall cost to citizens of the country I think would be equivalent.

I admit I have not done the maths to prove this and haven't seen anyone else do it either, not even Bill Mitchell who is a staunch advocate of governments funding deficits with currency issuance rather than debt. I'm aware that the relationship of currency issuance to inflation is disputed, and I should emphasise that the above paragraph is my personal opinion.

If I am right, though, then Quantitative Easing as conducted by the UK government cannot possibly be inflationary, since all it is doing is issuing one form of money to buy an equivalent quantity of another form of money. Yes, the government debt purchased is held, rather than being redeemed - but it is removed from circulation, which is what matters. And yes, the government still pays interest on that purchased debt, but only to itself (because it owns the Bank of England).

How governments get rid of debt

Note that I did not say "pay off" debt. Generally governments don't pay off debt. They refinance it - by which I mean that when one lot of debt falls due and has to be repaid, they issue some more debt so they can repay the debt that is maturing.

Nevertheless, government debts historically have reduced. The UK's public debt after World War II was considerably higher than it is now. At least that is what we are told by those who think that the way out of our economic difficulties is to issue loads more public debt.

The trouble is, it isn't true. The nominal amount of public debt only reduces if it is REPAID, which it hasn't been. What has actually happened is that UK public debt has reduced AS A PROPORTION OF NATIONAL INCOME. Government debt is nearly always quoted in relation to Gross Domestic Product (GDP). There are two ways in which the proportion of public debt to GDP can be reduced:

- GDP can ACTUALLY increase through economic growth (this is what happened in the 1950s and 1960s, when the UK was a young economy growing fast after the Depression and the War)

- GDP can APPEAR to increase through inflation (this is what happened in the 1970s after the OPEC oil crisis)

Either way, because the nominal amount of debt is fixed, it declines as a proportion of GDP. Obviously we like to reduce our debt/GDP ratio through growth and are much less happy about inflating it down, because inflation erodes people's savings and reduces their real incomes. But both methods are equally effective at reducing the debt/GDP ratio, so if growth is hard to come by and debt is a real problem (perhaps because investors are getting nervous about the amount of debt and demanding higher interest rates), it is very, very tempting to go for inflation.....

The relationship between government and private spending and saving

I mentioned above that a government that runs a surplus is depriving its population of the opportunity to provide for themselves, because it is overcharging them for public services. That government surplus represents LOST private sector savings and/or spending. Running a surplus in an economic downturn is counterproductive, because it reduces people's spending power. And it can be argued that running a surplus in a boom is unnecessary if public debt is under control, because people are perfectly capable of saving for themselves and don't need the government to do it for them.

Conversely, a government that runs a deficit is undercharging for public services. That means its population is paying less in tax than it should and therefore has the capacity both to spend more and to save more. In good times, undercharging for essential public services is in my view irresponsible. But in an economic downturn it can be helpful, if the problem is a failure of aggregate demand. For example, cutting taxes to low- and middle-income earners can be an effective way of stimulating demand. If the propensity of the population is to save, though, cutting taxes can simply allow people to save more, which doesn't help demand - this is the "paradox of thrift". A government that deficit spends excessively in a downturn when people prefer to save can end up with a stagnant economy and very high debt.

If the private sector (households and corporates) is highly indebted and paying off debt, government must run a deficit. This is because economically, paying off debt is the same as saving, and as I pointed out above, government surplus represents LOST private sector savings. The excess taxes that people pay when government overcharges for public services reduce their capacity to pay off debt. I hope this is clear to my readers, because it is a fundamental principle and one I shall return to in future posts.